How to avoid anchoring bias when investing

Markets have resumed their troubled times in the last few weeks, though the rationale for the quick recovery sighting possible docile approach towards interest rates by the US Federal Reserve in July turned brittle. Now, as the true essence of Fed's intentions understood, the markets went into a huge turmoil. Of course, some of the indices and stocks (tech and growth) have been in a downward spiral since the beginning of this calendar year sighting the squeeze of easy money.

So, when we look at some of the marquee names trading at a mouth-watering discount of 50 per cent and in some cases 70 to 90 per cent from their peak prices, which were trading till a few months back, it's easy for us to get drawn to them. Even in a day when the markets trade downward, many people rush to buy a particular stock as it crashed by some percentage.The discounted valuations suddenly categorize them from growth profile to value, which means they could be near or under their intrinsic valuations, at least at the first sight. But are they?

Amos Tversky and Daniel Kahneman in a 1974 paper demonstrated how 'people make estimates by starting from an initial value that is adjusted to yield the final answer.' These researchers found that even arbitrary numbers could lead participants to make incorrect estimates. In one study, they found that spinning a wheel of fortune in front of the participants and feeding them with random numbers influenced their answers.

The participants spun the wheel to select a number between 0 and 100. Then they were asked to adjust that number up or down to indicate how many African countries were in the UN. Those who spun a high number gave higher estimates than those who spun a lower number. In each case, the participants were using the initial number as their anchor point to base their decision. Basically, this adjustment of final value from the initial value while making an estimate or prediction is called anchoring, and this bias is known as anchoring bias.

To prove their theory the researchers, one of the foremost in the behavioural finance, have conducted a simple experiment with high school students. They asked them to make aguess of the answer to a mathematical equation in a short period of time. They gave five seconds to the students to make an estimate of: 8X7X6X5X4X3X2X1 while another set of students were given the same numbers in a reverse sequence of: 1X2X3X4X5X6X7X8.

The median estimate for the first equation turned out was 2,250 while that of the second was 512. The correct answer is 40,320. They argued that this difference is because the students were doing partial calculations in their heads and then trying to adjust these values to the get an answer. The group which was given the descending sequence of numbers was working with larger numbers to start with, hence a larger final answer and vice versa for the other group. This is what the researchers termed as anchoring bias. However, the same is not the case when the anchor is not generated on their own and is provided by some external source.

This is common in consumerist world where price 'mark down' is used during discount sales. An item which is priced at Rs 1,000 is offered at a discount of Rs 200, though the item at the first place isn't worth Rs 1,000. Anchoring bias in investing is a common phenomenon like I'd earlier mentioned about the discounted values of the stocks. Decisions based on such perspectives could mislead investors.

So, how could one avoid this ubiquitous and widespread bias in our decision making. Like many cognitive biases, anchoring bias happens subconsciously and at times difficult to identify. First is to do a thorough research on our behalf on why a particular anchor is inappropriate for the current situation. For instance, if a stock price has fallen from its previous highs, one need to understand the context or the reason for the fall. Is it due tomacro-economic situation, or a regulatory change or a business environment change or legal issues of the company, etc. The other is to evaluate a decision through a process of listing pros and cons or opposing and challenging an idea.

In case of our example of growth stocks, one needs to know what conditions allowed these stocks to outperform and what are the current reasons for the underperformance. What conditions were there from now i.e., parameters across multiple variables like liquidity, GDP growth, inflation, interest rates, etc. It's not only for stock prices that this bias would influence our decision making but in our many generally mundane things like estimates on cost of education, standard of living, etc, which drive our savings or investing decisions. One should recognize that we can't completely avoid these biases but a conscious effort by us would reduce the chances of committing this error.

(The author is co-founder of 'Wealocity,' a wealth management firm and could be reached at [email protected])